What is Meant by Double-Entry System?/Advantages, Examples
What is Meant by Double-Entry System?
Now we should understand what is meant by double-entry system. The double entry system is a scientific method of accounting under which all financial transactions of business are entered into two different sides of accounts called as debit side and credit side. The double-entry system of accounting is based on 3 basic accounting principles:
1. Debit what comes in Credit what goes out.
2. Debit the receiver Credit the giver.
3. Debit all expenses and losses Credit all gains.
In a double-entry system, all financial transactions of a business are entered into accounts based on the above financial principles. As aforesaid all financial transactions of a business are entered in two separate sides of accounts so that the total of all financial transactions entered in one side tally with the total of the other side.
For example, a business house A Bros, purchases goods worth Rs. 5,00,000 (5 lakhs) from ABC & Co. on credit. Now the entry in A Bros accounts will be:
Goods a/c 5,00,000
To ABC &Co. 5,00,000
Being goods purchased from ABC & Co on credit.
Thus this financial transaction is entered in both sides of accounts i.e. debit and credit. It applied the accounting principle, Debit what comes in Credit what goes out. A Bros. purchased goods worth Rs 5 lakhs so they received goods hence their account is debited from Rs. 5 lakhs and because they purchased goods from ABC & Co. their account is credited with that amount.
For example, if A Bros purchased goods of that amount in cash then the entry in A Bros account will be:
Goods A/c. 5,00,000
To ABC & Co. 5,00,000
In this way, if these goods were purchased partly in cash and partly in credit then entry in A Bros account will be according to that. Suppose A Bros purchased goods worth Rs 4 lakhs in credit and 1 lakh in cash then entry will be:
Goods A/c. 5,00,000
To ABC & Co. 4,00,000
Cash. 1,00,000
In this way, it is clear that the financial transactions of a business house are entered into two different accounts i.e. debit and credit. Now the question arises what is the use of entering a transaction in two sides.
The simple answer is that they cross-check with each other and because all financial transactions are entered on two different sides so total of both sides remains the same which ensures the correctness of all financial transactions entered into accounts.
This Accounting system remains the same from journal entries to the balance sheet. Therefore total of both sides of the balance sheet must tally otherwise the accounts will not be considered accurate and have to recompile them.
How Does the Double Entry System Work?
Accounting equations are the basis of double entry according system, which are as under:
Assets = Liabilities + Owner's Equity
Assets = Whatever the company owns like cash + land and building + stock + goodwill + bills receivable etc.
Liabilities = Whatever the company owns like bills payable + outstanding expenses + doubtful debts etc.
Owner's Equity = Investment of owner in the company which fluctuates with profile and loss of the company in a given period. It includes promoters + shareholders etc.
Income = income of the company comes from selling goods and services + other resources.
Expenses = expenses of the company means expenses made on running of business and other contingent expenses.
So the question is how accounting equations are the basis of a double-entry accounting system. We can easily understand it by the example below:
For example, A Bros purchased plant and machinery for Rs. 3,00,000 (3 lakhs) in cash for running their business. Though both cash and plant and machinery are assets and therefore it is the conversion of one type of asset to another type of asset therefore there will not be any difference in the assets side of the balance sheet but still, it is a part of the double-entry accounting system?
When we purchase plant and machinery in cash we receive plant and machinery and cash goes out from our business. So number 1 basic principle of accounting will apply here (Debit what comes in Credit what goes out). Now this transaction will be entered into our business accounts as:
Plant and machinery 3,00,000
To Cash 3,00,000
Being plant and machinery purchased from....in cash.
Another example is suppose A Bros paid salary to employees Rs. 1,00,000 for the month ending 31st March 2024. Now the journal entry will be:
Salaries A/c. 1,00,000
To Cash. 1,00,000
Being salaries paid in cash for the month ending 31st March 2024.
So every financial transaction must be entered in two different sides, i.e. debit and credit, in a double-entry Entry Bookkeeping System to ensure the correctness of accounts by tallying the total of both sides are equal at the end of a specific period.
Advantages of Double Entry Bookkeeping System
There are various types of accounting systems which different types of organizations adopt like double-entry accounting systems, single-entry accounting systems, etc. The most popular, accurate and transparent accounting system is double entry accounting system.
The double-entry accounting system is adopted by almost all companies because of its advantages and faith to all like shareholders, investors, tax authorities and others connected with the business of the company.
The main advantages of double entry accounting system are given as under:
1. Accuracy and Transparency - in a double-entry accounting system every transaction is recorded on two different sides of accounts i.e. debit and credit with the same amount. So when we total each side they are always equal which creates accuracy and Transparency in this system.
2. Accountability - this is one of the major advantages of a double-entry accounting system. Because every financial transaction is recorded on two different sides of accounts their totals are always equal and if not reason for it is deeply analysed. The top management along with others becomes accountable for it until they rectify it.
3. Creates Confidence in Tax Authorities - the accurate, transparent and accountable double-entry accounting system creates confidentiality in tax authorities. This accounting system is very simple to prepare and submit to tax authorities at the end of a specific period.
4. Helps in Managing Cash Flow - cash flow is the backbone of any type of business. Cash flow helps in Managing business transactions which entirely depends on cash. By double entry accounting system businesses can easily estimate probable incoming and outgoing of cash during a specific period by going through bills receivable, bills payable and other cash expenses to be incurred including cash inflow for running their business.
5. Helps in identifying Errors and Fraud - since in the double entry accounting system every transaction is recorded in two different accounts in debit and credit sides. So it is very difficult to cancel any type of error or fraud which is not possible in single entry accounting system.
For example, suppose a business purchased goods worth Rs. 10,000 in cash from ABC Co. Now in the double-entry accounting system, the entry will be:
Goods A/c. 10,000
To cash. 10,000
Being goods worth Rs 10,000 purchased in cash
This entry will be recorded in two different accounts i.e. cash account and goods account. Hence it will be next to impossible to make an error or fraud because this transaction is recorded in two different accounts so if a person erases entry from one account it will be caught from the other account and total in trial balance of both sides, debit and credit, will not be equal.
6. Makes Financial Reporting Simple - as described above all financial transactions in a double-entry accounting system are recorded in two separate accounts it makes Financial Reporting Simple and transparent. All general entries are recorded on two different sides from journal entries to balance sheets. Because all financial transactions are entered in the debit and credit sides of the trial balance and balance sheet it becomes easy and trustworthy for financial reporting.
Conclusion
As stated above, the double-entry accounting system is the most accurate, transparent and trustworthy for all concerned with the business of a company. Because the double entry accounting system is trustworthy to shareholders, financial institutions, creditors, and tax authorities, the management of the company gets confidence in business affairs and engages themselves to make important decisions for its upliftment.
Double entry accounting system provides accurate data about the financial health of the company in a specific period which helps shareholders, investors, and creditors to make future decisions about participation in the business of the company. Adoption of a double-entry accounting system also helps the company to follow a generally accepted accounting system that is a double entry accounting system.
Years ago double entry accounting system was very complex and costly. At that time only big companies adopted this accounting system and hired expert accountants to prepare their accounts but now various accounting software make this work easy and even middle-sized or small companies started adopting a double-entry accounting system. This software prepares their accounts even based on International Financial Reporting Standards (IFRS).